Example of Problems Arising with Full Absorption Costing
The above example assumes that there will be 100,000 labor hours in a year and is allocating the overhead costs to each unit produced, on the basis of that estimate. If that is indeed the case, then 1,000 units of the product can be produced in a year, and at a sale price of $50,000 each, the sales revenue will be $50 million for the year. The direct costs will be $30 million and the overhead costs $10 million as stated above, so the profit would be computed at $10 million for the year. The costing system would be giving a true picture of the profit element earned by each unit.
However if the factory is not operating at full capacity, for example because there is an economic downturn and the orders for the product have fallen, then the number of direct labor hours falls, and the output of units of the product also falls. As the absorption rate of overheads into each unit of product is determined based on estimates at the beginning of the year, the result is that at the end of the year, there is a discrepancy between the actual amount of overhead expense incurred in the year, and the amount of overheads that have been absorbed into the cost of the product for costing purposes.
For example, if the output in a year falls to 800 units, but the costing set up at the beginning of the year has projected an output of 1,000 units, only 80% of the projected overhead costs will have been absorbed into the costing of the products manufactured. Although the reduced output may have resulted in some lower overheads, there are also fixed overhead costs such as salaries of administrative staff that remain the same. This example of an absorption costing calculation, shows that overheads are not being fully absorbed into the cost of the products.